Kevin Warsh has resigned after five years on the Fed's Board of Governors. In his resignation letter to President Obama, he expressed the honor he felt to have served at a time of great consequence and the privilege to have worked alongside Chairman Bernanke.
The timing of Warsh's resignation will be interpreted as part of the growing opposition to QE2, especially given the strength in recent economic indicators including today's decline in initial jobless claims to 383,000. Warsh's oped in the November 8 Wall Street Journal expressed reservations about the Fed's QE2 policy "“ "The Fed's increased presence in the market for long-term Treasury securities poses nontrivial risks that bear watching"¦ Should these risks threaten to materialize... I am confident that the FOMC will have the tools and conviction to adjust policies appropriately." In its Federal Open Market Committee statements, the Fed has said it "will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."
I expect Chairman Bernanke to maintain full control of the FOMC and the QE policy. Bernanke is conscious of the views of the critics, but his recent appearances (February 3 at the National Press Club and February 9 at the House Budget Committee) showed no sign of altering QE2. The FOMC is made up of the 6 current Fed governors including the chairman (one seat vacant) plus 5 of the 12 regional Federal Reserve bank presidents. Of the Fed Presidents, Lacker, Fisher, Plosser and Hoenig have already expressed strong criticism of QE2, with milder reservations from some others. Hoenig dissented on QE2 in 2010 when he was a voting member. All voting members including Fisher and Plosser supported QE2 in the January FOMC statement.
What If QE2 Winds Down?
As the economy strengthens, Chairman Bernanke and the FOMC might still change direction, deciding on a gradual wind-down of QE2 in which the Fed reduces the $600 billion target or, more likely, maintains the ultimate target of $600 billion but slows the net purchases now at roughly $70 billion per month.
Under the conventional analysis, the Fed is an arms-length bond buyer in which QE2 drives down bond yields by adding to the demand for bonds. Under this view, a reduction in QE2 would increase Treasury bond yields by removing the major buyer (the Fed now owns more Treasuries than the Chinese). This view argues that bond yields would have been even higher today if not for QE2 and will increase when QE2 stops. We disagree.
In contrast, we've argued that the Fed is not "?printing money' because almost all of the funding for the purchases is coming from excess reserves. QE2 is not increasing the amount of private sector credit but rather reducing its holdings of Treasury notes and bonds and increasing its deposits at the Fed. As such, there's no money multiplier or monetary stimulus through commercial banks. Under this interpretation, QE2 is a buy-back of outstanding Treasuries, funded overnight. QE2 adds to the maturity risk of the U.S. government by shortening the effective maturity of the national debt, while reducing the maturity risk of the private sector. This is the equivalent of having Treasury issue less long-maturity debt and more short-maturity debt (which the Fed is accomplishing by borrowing overnight excess reserves from commercial banks.) I think winding down QE2 would lower Treasury bond yields and strengthen the dollar by reducing the maturity risk and would reduce gold and commodity prices by increasing market confidence in the Fed.
We think the Fed's rapidly rising bond holdings are a weakness in the long-term U.S. growth outlook, and an early wind-down would strengthen U.S. economic policy. This is especially important at a time when federal spending is out of control. My November 15 open group letter to Chairman Bernanke said: "We believe the Federal Reserve's large-scale asset purchase plan should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances"¦ We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy"¦ The Fed's purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems."
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